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Small cap quality shines through

By: Tom Goodwin, senior research director

US small caps have undergone some significant style shifts over the last year (see our recent blog post). In the months immediately following the US election, the Russell 2000 style indexes showed a strong trend towards value while the most recent months have switched equally towards growth. It’s enough to give one a case of the bends.

Yet there may be an antidote for this condition. The Russell 2000 Dividend Growth Index includes companies with high dividend growth (2.47% as of 31 August 2017 compared to 1.33% for the Russell 2000 Index over the same period) plus small cap exposure. With dividends reinvested, its relative performance compares favorably to its benchmark as the table and chart show. Not only have the returns been higher than the parent Russell 2000 Index since going live, but volatility and drawdowns have been substantially less. 

  

But it is not just dividend payments that are behind this success. The index selects companies within the Russell 2000 Index that have increased dividends every year for ten years. This avoids the “yield trap” where a stock can have a high dividend yield just because the price has fallen, often for good reason.

We can get a more detailed look at what’s going on with this index through the lens of a factor analysis, starting with the well-known three-factor model of Fama and French.[1] The model targets three factors that are a standard part of the model: Market Beta, Small Cap exposure and Value exposure. We can also add a fourth factor, Quality, that comes out of more recent research.[2]

The following table shows the results of running a regression of the return of the Russell 2000 Dividend Growth Index over a cash return on the four factors, each of which I’ll briefly describe.

Market Beta measures how much the Russell 2000 Dividend Growth Index is sensitive to volatility in the whole stock market, both large and small caps. A coefficient of 1.0 or greater would mean that the index is very sensitive to market volatility. We see that in fact the Market Beta is well below 1.0, indicating a relatively low sensitivity to broad market fluctuations leading to lower volatility and drawdowns, which we saw in the previous table.

Small Cap is the return to a long-short portfolio of stocks that is long in small cap stocks and short in large cap stocks. The coefficient measures the index’s loading to the Small Cap factor return, and it is no surprise that it is statistically significant.

Value is the return to a long-short portfolio that is long in high book-to-price stocks and short in low book-to-price stocks. The coefficient measures the index’s loading to these stocks with low prices relative to sales. Interestingly, the coefficient is positive and statistically significant, indicating that higher dividend paying and dividend growing stocks tend to have better valuations.

Quality is the return to a long-short portfolio that is long in stocks with strong profitability growth, high return on assets and low volatility, among other things. The portfolio is short those stocks with the opposite characteristics. We can see that the estimated loading of the index to high Quality is large and statistically significant, about the same size as Market Beta and Small Cap loadings.

The factor analysis shows that, by selecting companies that have successfully increased their dividend payments over many years, the Russell 2000 Dividend Growth Index occupies a corner of the small cap space that is high in the Quality factor. The returns to the Small Cap and Value factors have varied significantly over the last couple of years, but the Market Beta and Quality factors have shone through, buoying up the performance of the index. Those two factors combined with the Small Cap factor makes for three strong drivers of index performance.

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[1] Fama, E. and K. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992; Fama, E. and K. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 1993.

[2] Asness, C., Frazzini, A., and Pedersen, L. (2014), “Quality minus Junk,” Working paper AQR Capital Management Inc.

 

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